There aren’t many certainties when you’re building a company from the ground up. But one thing nearly all entrepreneurs face is the need to raise money to help their business grow. Unfortunately, many startups believe the only way to raise capital is by giving up large amounts of equity. They’ll spend months or years running from meeting to meeting, trying to land that big venture capital deal.
While fundraising is considered a rite of passage for most startups, raising a round of equity takes up a huge amount of time, energy and enthusiasm. It’s estimated that less than 1% of companies that seek funding from a VC fund end up getting an investment, so it’s a huge accomplishment if you do make it happen. But as someone who’s been both a VC and entrepreneur, I can tell you firsthand that raising equity can be a time and soul-sucking process. The good news is that there are now more ways for small businesses to get growth funding than chasing after VCs looking for the next unicorn.
If you’re leading a startup or small business looking at financing options, it’s important to understand how VCs work and what they’re looking for. Here are some key things to consider:
- VCs swing for the fences. They’re looking for companies with “gotta have” technologies that will disrupt entire industries.
- Early-equity investors (Seed and Series A) are looking for at least 10-20x returns and a large ownership stake. So the math is pretty simple: a $2 million investment needs to provide a $20 to $40 million return. That means if a VC invests in your company at $4 million pre-money ($6 million post) they’ll start with 33% ownership and maybe end at 15-20% ownership if you raise another round or two. You’re basically selling part of your company. Once they invest, VCs are hoping you sell your company for at least $100-200 million. Exits near or above $100 million are rare.
- Be sure you want that “ride” – I compare receiving a large amount of VC funding to having a rocket strapped to your back – either you’ll make it to the moon or you’ll blow up trying. The truth is that many small companies aren’t ready to use a large amount of capital. What they find they really need are small amounts of funding at intervals to scale the way that’s best for the business.
With all of that as background, here the three main instances when I believe you should not give up equity.
1. You’re not ready to sell your business (or a part of it)
Some early investors will not only want a percentage of equity, they’ll want to be involved in your business as an adviser, weighing in on decisions about how you run your company. In general, VCs are paid to be involved like this, while angel investors may be heavily involved or not involved at all. If you don’t want to give up control in this way, equity is probably not the right choice for you.
Along the same lines, don’t enter into an equity arrangement if you don’t want to introduce new “partners” in the business. And be sure you like the partner investors, because you’ll be with them for a long time – the average Series A investor waits 7 years for liquidity – it lasts about as long as the average marriage, which is why I sometimes say, “Until liquidity event do you part.”
2. Your business isn’t showing solid traction with a disruptive offering
As noted earlier, VCs are looking for companies with game-changing technologies that will disrupt entire industries. They’re looking for signs the market values your offering in the form of traction via revenue or significant customer adoption (or both). So if you’re going to sell the business for $100 million or more, early equity investors need to see big upside via an offering that will change an industry.
If you don’t have a disruptive product or service, equity investors will need to own a huge percentage of your company to make their 10-20x return, and you’ll likely end up selling off too much of the company. Additionally, you’ll find it really hard to raise equity funding without a disruptive offering, and you’ll spend many months (or years) raising money instead of building your company, which means the business will suffer.
3. You don’t need equity investor money
If your business is already capital efficient, you may not need too much money to continue growing. Additionally, you can get money from other sources, such as a RevenueLoan that don’t have the same ownership and control requirements as VC funding, so they’re not dilutive.
Just to be clear: I don’t think venture capitalists are “mad, bad and dangerous to know” – remember, I’ve been a VC myself. And there are lots of amazing companies that truly need VC money to grow and be successful. But I do think if you’re looking at funding options for your startup, you should go in armed with as much information as possible, because many times there are better and easier ways to fund your growing small business.
– BJ Lackland is the CEO of Lighter Capital